High Yield Bonds

What is High Yield Bonds?

High yield bonds are bonds issued by a corporation that has been assigned below investment grade threshold by popular credit rating agencies such as below “BBB” from Standard & Poor and below “Baa” from Moody’s due to additional credit risks involved in interest and principal repayment. However, to compensate for higher default risks, these bonds offer attractive returns to investors.

Features of High Yield Bond

• High Yield Bond varies with regard to coupon and maturity types. Many of the most common structures are designed to allow issuers to improve cash flow by deferring interest payments.
• The highest yield bond is an unsecured senior debt obligation. By contrast, leveraged loansLeveraged LoansLeveraged loans are loans that have a high risk of default in repayment since they are offered to firms or individuals that already have considerable levels of debt and may have a poor history or credit as a result of which such loans have a high rate of interest.read more are usually secured on particular assets.
• Covenant on high yield loans may restrict certain activities or payments by the issuer detrimental to the interest of the creditor. Most high yield loans incorporate a change in control put.
• The primary market for high yield loans is dominated by the small number of major investment banks, whereas secondary marketsSecondary MarketsA secondary market is where securities are offered to the general public after being offered in the primary market. Such securities are usually listed on the stock exchange. A significant portion of trading happens in such a market and are of two types – equities and debt markets.read more is an OTC market wherein the bulk of transaction are negotiated between dealers and investor.

High Yield Bonds Types

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• Zero-Coupon Bonds – This issue deep discount and redeemable at par. No interest is accruedInterest Is AccruedAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.read more and paid to the bondholder
• Deferred Interest – In the deferred interest, Deferred Interest, Deferred interest refers to the delayed interest payment on a loan in a certain period. The borrower need not pay any interest if the whole loan amount is cleared within this period. Such interest is usually charged on credit cards and negative amortization.read moreno interest payment until later in the bond’s life. Thereafter higher coupons are paid to make up the shortfall.
• Step-Up Bonds – Initial coupons are low, increasing at later dates.
• Pay in kinds of Bonds – It replaces coupons with additional debts. The additional debt will carry a higher coupon rate than the original but are very risky in nature. If the issuer continues to pay in the form of additional debt as the number of outstanding debts of the company will significantly increase.
• Equity-Linked Bonds – Which gives the right to the holder to convert is bondholding to equity holding such as convertible bonds.
• Extendable Reset Notes – The issues have the right to extend the maturity of outstanding debt with the new coupon at periodic intervals. It also has additional features of put optionsFeatures Of Put OptionsPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more where the investor can sell back the bond to the issuer.

Who are the Investors in High Yield Bonds?

• Retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more do not participate in this market due to a lack of financial and technological resources to monitor key credit issues or day on the daily activities of the borrower. Institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more such as Insurance companies (these are one of the big investors who want heavy returns to fund their annuities).
• Pension fundsPension FundsA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more (invest in bonds to increase their earnings but often are subject to regulation in investing in high-risk portfolio), hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more or investment funds (these are aggressive investors and invest a large portion of their portfolio in realizing the quick gain and are subject to no regulation) are a major participant in this market.

Who are the Borrowers?

High yield financing has played a prominent role in certain sectors such as technology, media, energy, IT infrastructure. Companies in these sectors have a high debt burden relative to their earnings and cash flow. Some are startup companies or well-established companies restructuring, or high yield loans are used to finance the leveraged buyoutLeveraged BuyoutLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read more, refinancing existing loans, acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more, takeovers, etc.

High Yield Indexes

• Standard & poor high yield corporate bond index
• CSFB high yield II index
• Bloomberg USD high yield corporate-based index
• FINRA Bloomberg active high yield US corporate bond index
• Barclays high yield index
• Citigroup US high yield market index

Advantages of High Yield Bonds

• Enhanced Spread – High yield offers significant spread over treasury securities. In 1980-1990 US high yield bonds offered 300-500 basis pointsBasis PointsBasis points or BPS is the smallest unit of bonds, notes and other financial instruments. BPS determines the slightest change in interest rate, to be precise. One basis point equals 1/100th part of 1%.read more relative to US treasury of comparable maturity. For some investors, it can fetch significantly higher returns in a small period of time than any other offering
• Diversification – High yield loans are treated as a separate asset class that exhibits low correlation with other fixed-income securitiesFixed-income SecuritiesFixed income investment is a type of investment in which the investor receives a fixed and relatively stable stream of income in the form of dividends or interest over a period of time. Companies and governments typically issue fixed investments in the form of debt securities.read more, which help to provide consistency in returns and lowers overall portfolio risks.
• Security – High yield investors are given priority on repayment of capital over common and preferred stockholders in the event of a liquidationEvent Of A LiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more. Many investors feel that High yield investments are not as safe as the entire amount is lost during default, but this is not true as investors do recover some portion before other class of shareholders. In other words, it’s much safer as compared to stock issues by the same company.
• Low Duration – The inclusion of high yield loans in the portfolio will help to lower the overall durationDurationDuration is a risk measure used by market participants to measure the interest rate sensitivity of a debt instrument, e.g. a Bond. It tells how sensitive is a bond with respect to the change in interest rates. This measure can be used for comparing the sensitivities of bonds with different maturities. There are three different ways to arrive duration measures, viz. Macaulay Duration, Modified Duration, and Effective Duration.read more due to shorter maturity. These are typically issuing with 8-10 years maturity and often callable within 3-5 years.

Disadvantages of High Yield Bonds

• Default Risks – During economic stress, defaults may spike, making the asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more more sensitive to the economic outlook. High yield borrowers often fail to make scheduled interests and principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more, which are very high as compared to conventional loans.
• Downgrade Risks – Due to a change in credit quality, a credit rating downgrade these bonds leading to a significant change in its value.
• Economic Risks – High yield loans are very sensitive to corporate earnings and economic outlook than a day to day fluctuations in interest rate. In the rising interest rate environment, these are expected to outperform other fixed-income loans. However, during economic crises, these are more prone to default.
• Liquidity Risks – Due to its risky nature and limited supply, it’s very difficult to find investors in these markets, which results in lowering the overall liquidity, widening bid-ask spread, and transaction costs.
• Interest Rate Risks – Interest Rate RiskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more refers to a change in the market value of a bond due to a change in interest rate. However, these are less affected by the increase in interest rate as compared to other fixed-income instruments due to low correlation.
• Event Risks – Event RiskEvent RiskEvent Risk is the probability of an unexpected event that has the potential to negatively impact an organization, sector, or stocks. An event risk may arise out of any change in the market trends which may impact the current state of the organization or the sector. read more refers to poor management, failure to anticipate shifts in the market, the rising cost of raw material, regulatory changes, change in management, competition can significantly affect the whole industry.

Conclusion

A major attraction of high yield bonds is that it seems to generate both equity-like returns with bond type risks. Studies have shown High yield market has a negative correlationNegative CorrelationA negative correlation is an effective relationship between two variables in which the values of the dependent and independent variables move in opposite directions. For example, when an independent variable increases, the dependent variable decreases, and vice versa.read more with the government bond market and low positive to zero with equities and investment-grade bonds.

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